1.

IMPORTANCE OF THE INTERNATIONAL CAPITAL MARKET

A capital market is a system that allocates financial resources in the form of debt
and equity according to their most efficient uses. Its main purpose is to provide a
mechanism through which those who wish to borrow or invest money can do so efficiently.
Individuals, companies, governments, mutual funds, pension funds, and all types of
nonprofit organizations participate in capital markets. For example, an individual might
want to buy her first home, a midsized company might want to add production capacity,
and a government might want to support the development of a new wireless
communications system. Sometimes, these individuals and organizations have excess cash
to lend, and, at other times, they need funds.

a. Purposes of National Capital Markets

There are two primary means by which companies obtain external financing: debt
and equity. National capital markets help individuals and institutions borrow the money
that other individuals and institutions want to lend. Although in theory borrowers could
search individually for various parties who are willing to lend or invest, this would be an
extremely inefficient process.
 Role of Debt
Debt consists of loans, for which the borrower promises to repay the borrowed
amount (the principal) plus a predetermined rate of interest. Company debt normally
takes the form of bonds—instruments that specify the timing of principal and interest
payments. The holder of a bond (the lender) can force the borrower into bankruptcy if
the borrower fails to pay on a timely basis. Bonds issued for the purpose of funding
investments are commonly issued by private-sector companies and by municipal,
regional, and national governments.
 Role of Equity
Equity is part ownership of a company in which the equity holder participates with
other part owners in the company’s financial gains and losses. Equity normally takes
the form of stock—shares of ownership in a company’s assets that give shareholders
(stockholders) a claim on the company’s future cash flows. Shareholders may be
rewarded with dividends—payments made out of surplus funds—or by increases in the
 value of their shares. Of course, they may also suffer losses due to poor company
performance and thus experience a decrease in the value of their shares. Dividend
payments are not guaranteed but are determined by the company’s board of directors
and are based on financial performance. In capital markets, shareholders can sell one
company’s stock for that of another or can liquidate them—exchange them for cash.
Liquidity, which is a feature of both debt and equity markets, refers to the ease with
which bondholders and shareholders can convert their investments into cash.
b. Purposes of The International Capital Market
The international capital market is a network of individuals, companies, financial
institutions, and governments that invest and borrow across national boundaries. It consists
of both formal exchanges (in which buyers and sellers meet to trade financial instruments)
and electronic networks (in which trading occurs anonymously). This market makes use of
unique and innovative financial instruments specially designed to fit the needs of investors
and borrowers located in different countries. Large international banks play a central role
in the international capital market. They gather the excess cash of investors and savers
around the world and then channel this cash to borrowers across the globe.
 Expands The Money Supply for Borrowers
The international capital market is a conduit for joining borrowers and lenders in
different national capital markets. A company that is unable to obtain funds from
investors in its own nation can seek financing from investors elsewhere. The option of
going outside the home nation is particularly important to firms in countries with small
or developing capital markets of their own.
 Reduces The Cost of Money for Borrowers
An expanded money supply reduces the cost of borrowing. Similar to the prices of
potatoes, wheat, and other commodities, the “price” of money is determined by supply
and demand. If its supply increases, its price—in the form of interest rates—falls. That
is why excess supply creates a borrower’s market, forcing down interest rates and the
cost of borrowing. Projects regarded as infeasible because of low expected returns
might be viable at a lower cost of financing.
 Reduces Risk for Lenders
 The international capital market expands the available set of lending opportunities.
In turn, an expanded set of opportunities helps reduce risk for lenders (investors) in two
ways:
1) Investors enjoy a greater set of opportunities from which to choose. They can thus
reduce overall portfolio risk by spreading their money over a greater number of
debt and equity instruments. In other words, if one investment loses money, the loss
can be offset by gains elsewhere.
2) Investing in international securities benefits investors because some economies are
growing while others are in decline. For example, the prices of bonds in Thailand
may follow a pattern that is different from bond-price fluctuations in the United
States. Thus, investors reduce risk by holding international securities whose prices
move independently. Would-be borrowers in developing nations often face
difficulties trying to secure loans. Interest rates are often high, and borrowers
typically have little or nothing to put up as collateral. For some unique methods of
getting capital to small business owners in developing nations, see this chapter’s
Global Sustainability feature, titled “Big Results from Microfinance.”
c. Forces Expanding The International Capital Market
Around 40 years ago, national capital markets functioned largely as independent
markets. But since that time, the amount of debt, equity, and currencies traded
internationally has increased dramatically. This rapid growth can be traced to three main
factors:
 information Technology
Information is the lifeblood of every nation’s capital market because investors need
information about investment opportunities and their corresponding risk levels. Large
investments in information technology over the past two decades have drastically
reduced the costs, in both time and money, of communicating around the globe.
Investors and borrowers can now respond in record time to events in the international
capital market. The introduction of electronic trading that can occur after the daily close
of formal exchanges also facilitates faster response times.
 Deregulation
 Deregulation of national capital markets has been instrumental in the expansion of the
international capital market. The need for deregulation became apparent in the early
1970s, when heavily regulated markets in the largest countries were facing fierce
competition from less regulated markets in smaller nations. Deregulation increased
competition, lowered the cost of financial transactions, and opened many national
markets to global investing and borrowing. But the pendulum is now swinging the other
direction as legislators demand tighter regulation to help avoid another global financial
crisis like that of 2008–2009
 Financial Instruments
Greater competition in the financial industry is creating the need to develop innovative
financial instruments. One result of the need for new types of financial instruments is
securitization—the unbundling and repackaging of hard-to-trade financial assets into
more liquid, negotiable, and marketable financial instruments (or securities). For
example, a mortgage loan from a bank is not liquid or negotiable because it is a
customized contract between the bank and the borrower. But agencies of the U.S.
government, such as the Federal National Mortgage Association, guarantee mortgages
against default and accumulate them as pools of assets. Securities that are backed by
these mortgage pools are then sold in capital markets to raise capital for investment.

Securitization is criticized for the excessive debt that financial institutions took on in
the boom years prior to 2007. When investors lost faith in securities backed by sub-prime
mortgages, they sold their investments and helped spark the global credit crisis of 2008–
2009. Although the trigger for the crisis was lost value in mortgage-backed securities,
legislators soon began exploring the option of placing reasonable limits on securitization
in order to discourage an appetite for excessive levels of debt.

d. World Financial Centers

The world’s three most important financial centers are London, New York, and
Tokyo. But traditional exchanges may become obsolete unless they continue to modernize,
cut costs, and provide new customer services. In fact, trading over the Internet and other
systems might increase the popularity of offshore financial centers.
 Offshore Financial Centers
An offshore financial center is a country or territory whose financial sector features
very few regulations and few, if any, taxes. These centers tend to be economically and
politically stable and tend to provide access to the international capital market through
an excellent telecommunications infrastructure. Most governments protect their own
currencies by restricting the amount of activity that domestic companies can conduct
in foreign currencies. So, companies that find it hard to borrow funds in foreign
currencies can turn to offshore centers. Offshore centers are sources of (usually
cheaper) funding for companies with multinational operations. Offshore financial
centers fall into two categories:
1) Operational centers
Operational centers see a great deal of financial activity. Prominent operational
centers include London (which does a good deal of currency trading) and
Switzerland (which supplies a great deal of investment capital to other nations).
2) Booking centers
Booking centers are usually located on small island nations or territories with
favorable tax and/or secrecy laws. Little financial activity takes place here. Rather,
funds simply pass through on their way to large operational centers. Booking
centers are typically home to offshore branches of domestic banks that use them
merely as bookkeeping facilities to record tax and currency-exchange information.
Some important booking centers are the Cayman Islands and the Bahamas in the
Caribbean; Gibraltar, Monaco, and the Channel Islands in Europe; Bahrain and
Dubai in the Middle East; and Singapore in Southeast Asia.